Andrew McLaughlin is vice-president of legal affairs and general counsel at Major Drilling
ESG ratings providers are popping up like dandelions and sucking up too much sunlight.
The cast of players includes MSCI, Sustainalytics, ISS, Glass Lewis and Bloomberg, with new entrants joining the list seemingly every few months. Each uses its own methodologies to rank and score publicly traded companies based on their purported environmental, social and governance risk and performance. The reports produced are at times rife with inaccuracies. While the more obscure reports might not warrant a second glance, others can’t be ignored, as these inevitably land in the hands of investors and potential investors alike.
This crowded ratings landscape of wildly varying quality sows confusion in the markets, and consumes the bandwidth of companies as they scramble to address misstatements that pop up in these reports – taking valuable time that could be much better spent on actually improving ESG performance.
Thankfully, there is hope on the horizon as pressure grows to bring consistency and standardization to the Wild West of ratings.
As the vice-president of legal affairs and ESG lead at my company, I was charged with launching our ESG framework in early 2020. Since then, I’ve been making the case for the important role that in-house counsel can play in this area, and have written about our company’s ESG journey. Through this, I’ve become convinced that the business case for ESG has been made and that embedding an ESG-minded culture into our organization is crucial for us to survive and thrive.
I’m also convinced that the ever-growing roster of ESG ratings providers and reports puts a drag on the otherwise incredible momentum of ESG in the public markets.
Whenever a newly minted ESG report on our company lands in my inbox out of the blue, I start by holding my nose and asking: How far off the mark will this one be? It took about 15 seconds of skimming a recent report to identify the first of many glaring errors (and a significant one at that). Astoundingly, it was a statement that clearly contradicted the agency’s own findings in separate reports they publish.
My standard approach for these misguided reports is to just take it on the chin, resign myself to the notion that it’s a flawed system, and then decide if it’s worth dedicating resources trying to rectify inaccuracies. But after having seen this same movie played out over and over (along with the gravity of the error in this case), I took a step back to question the broader damage this dynamic is having on the public markets: both in terms of sowing confusion among investors, and, by diverting valuable company energy and resources toward correcting these agencies’ errors.
This needs to be called out.
Unfortunately, this wasn’t a one-off, but rather just the latest in a growing catalogue of erroneous reports, and a clear sign that there’s something fundamentally amiss about the broader ESG ratings industry.
Once these agencies are engaged to correct deficiencies, the radical alterations their reports can undergo is telling. There are cases of companies being able to dramatically reduce their “ESG risk” scores after such engagement. This is not achieved by changing anything about the way these companies actually operate, but rather, simply by pointing the ratings agencies to the relevant information – most of which is readily available in public disclosures, through a cursory Google search, or both.
On doing some digging, it’s quickly become evident that I’m not alone in my assessment of the ESG ratings industry – far from it. There is a growing consensus among a range of actors (reporting issuers, investors, academia, and even international institutions such as the OECD) that something needs to be done. For example, MIT’s Aggregate Confusion Project was born out of the need to address the low levels of correlation and consistency across ESG ratings, and seeks solutions to bring coherence to this field and cancel out the noise.
There’s another damaging undercurrent related to the business model employed by many of the ESG ratings agencies. They are often plagued by the same apparent conflict of interest long identified in the proxy advisory ecosystem more generally – that is, on the one hand, these ratings agencies assign scores to companies based on their “ESG risks,” and then on the other hand, these same agencies charge handsome consulting sums to companies wishing to improve their scores.
Some of these agencies also provide companies “early access” to consult on draft versions of their reports, but again, only for a fee. There’s some irony in being graded on things such as “governance practices” by firms that operate under this model.
Recognizing these significant weaknesses, a growing number of institutional investors are relying more on assessments undertaken in-house, where they have the luxury of large teams of analysts. Unfortunately, these ESG ratings reports remain widely disseminated go-tos for a broad range of other investors who simply don’t have the time or expertise to undertake their own research.
A major part of my role leading on ESG in my company is to build that ever-important buy-in across all levels of our organization. These efforts are severely undercut when the C-suite is blindsided by an ESG ratings report that misses the mark entirely.
Thankfully, it appears that the days of ESG ratings providers operating largely without regulatory oversight and accountability are numbered.
In January, for example, the SEC in the United States issued for the first time a staff report listing ESG rating practices as a key examination focus. In November, 2021, the board of the International Organization of Securities Commissions issued a report calling for more oversight by securities regulators on ESG ratings and data products providers. And perhaps most significant of all was the creation of the International Sustainability Standards Board at the COP26 climate change conference. The board is tasked with developing a comprehensive set of baseline sustainability standards for global use.
These developments should infuse some much-needed accountability into this field and help clarify and declutter the road ahead for reporting issuers that are genuinely looking to move the needle on ESG.
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